“A typical unqualified audit opinion is one in which the auditor has no reservations concerning the financial statements. An audit report expressing an unqualified opinion contains three paragraphs. The first paragraph, known as the introductory paragraph, lists the financial statements that were audited, states that management is responsible for those statements, and asserts that the auditor is responsible for expressing an opinion on them.

“The second paragraph, referred to as the scope paragraph, describes what the auditor has done. It states that the auditor has examined the financial statements in accordance with generally accepted auditing standards and has performed appropriate tests.

“The third paragraph, known as the opinion paragraph, gives the auditor's opinion regarding the financial statements described in the introductory paragraph, i.e. that they are presented fairly in conformity with generally accepted accounting principles.

“In other circumstances, a modified opinion, a qualified opinion, and adverse opinion or a disclaimer of opinion might be expressed. A modified report includes a fourth explanatory paragraph. The two most common types of modified reports are the result of material uncertainties and changes in accounting principles. A qualified opinion states that except for the effects of the qualified item, the financial statements present fairly the information in conformity with GAAP. An adverse opinion states that the financial statements do not present fairly the information in conformity with GAAP. A disclaimer of opinion states that the auditor does not express an opinion.”

Financial Statement Analysis, Charles J. Woelfel (1993)

The main annual reporting period for financial companies will occur over the next few weeks. If this is going to be a problem, the first indication will be observed as either a) a delay in the financial report of some mid-size financial corporation, or b) the appearance of audit opinions that are not entirely “unqualified.” While it's generally not problematic for an audit opinion to include a fourth paragraph noting a change in accounting method, those changes should always be interpreted by asking what, if anything, a company might have gained by doing so. Expressing a material uncertainty, or going so far as to express an adverse opinion or disclaimer of opinion, could potentially be a major blow not only to the company in question, but to the stock market as a whole. These reports will be worth monitoring.

As I noted last week, there is only one point where I have any particular view at all about near term market direction, and that is when the market is either overbought in an unfavorable Market Climate or oversold in a favorable one. Coming off of an overbought condition in an unfavorable Climate, last week's plunge was about par for the course. At present, we've cleared that overbought condition, so there's nothing that would allow us to form pointed short-term expectations for market returns. Presently, the Market Climate remains broadly unfavorable, and that is enough to hold us to a fully hedged investment stance in the Strategic Growth Fund.

Consumer and technology stocks held up nicely last week, which is early but certainly not conclusive evidence that the pressure on these sectors is abating. After all, a large number of consumer discretionary stocks are currently trading at valuations that implicitly set long-term growth expectations for this sector at about zero.

It tends to be the case that consumer oriented stocks achieve their lows well in advance of broad market lows. My guess is that we haven't reached that point quite yet – but even if stocks are in a bear market, I would expect to see the consumer and technology sectors lose less, over the full course of a market decline, than other sectors. In any event, our own stock holdings are diversified across nearly all sectors except financials, so though we do have greater weights in consumer and technology, it's largely because the weight we aren't allocating to financials has to be invested somewhere else.

Interest rate trends remain fairly constructive, but levels are unusually depressed. As I noted in “Interest Rate Intuition” last July, “when stock valuations have been above average (again, defined here as just roughly 14 times the highest level of trailing net earnings achieved to-date) and interest rates have been low (below 6% on the 10-year Treasury yield), overall market performance has been tepid regardless of the trend of yields. In the 16% of history when we've observed high valuations with low and falling interest rates, the S&P 500 has achieved an average annualized total return of 6.22%. Combining high valuations with low and rising interest rates (which has occurred just as often), the average annualized total return has been 5.41%.”

The strongest factor driving market returns here is the unfavorable condition of market internals including price/volume behavior, breadth, leadership, industry action, credit spreads, and other factors. Meanwhile, it's important to reiterate that P/E ratios based on “forward operating earnings” and even our own “price/peak-earnings” measures are somewhat corrupted here by the fact that the earnings in these ratios implicitly assume the continuation of record profit margins about 40-50% above long-term norms. As a result, we are also attending to measures that take profit margins into account more explicitly. To the extent that profit margins are not likely to be sustained indefinitely, P/E ratios are likely to be a poor metric of valuation, encouraging investors to believe that stocks are cheap on the basis of recent earnings, when they are not at all cheap on the basis of long-term earnings power.

This concern is reinforced by Jeremy Grantham in this week's Barrons, who noted “I have yet to meet a private-equity firm that put into its spreadsheet the assumption that system-wide profit margins could decline by 20% to 30%. They have taken the current, abnormally high profit margins as a given and then determined to improve them by, let's say, 15% and assume everything works out pretty well. But if the base declines by 20%, even if they end up improving margins by 15%, they are going backwards. And if they pay the 25% premium up front, which was normal, and if they leverage 4-to-1, which was normal, then they almost precisely wipe out all of the clients' money, all of the 20% in equity and if, perish the thought, they don't add 15%, but add perhaps zero to 5%, then they do more than wipe out the equity, they leave the underlying debt in ragged disarray. That is the next shoe to drop on the credit side.”

In any event, our own investment stance will be driven by the overall evidence we observe regarding both valuations and market action. As usual, we don't require the market to decline to undervalued levels to warrant a substantial or complete removal of our hedges, but we don't accept market risk in conditions where stocks have not materially outperformed Treasury bills, on average. As of Friday, the S&P 500 has underperformed Treasury bills since November 2005, and on a longer-term basis, has underperformed Treasury bills since April 1998 – almost a decade. At the point where a recession is taken as common knowledge, or the S&P 500 is down a full 20% from its highs on a closing basis (somewhere below 1250), I would expect an increased potential for a sustainable advance, if only an extended bear market rally as we saw a few times during the 2000-2002 period. Presently, however, it's clear that the idea of an oncoming recession is still a matter of heated debate. That's not what one usually considers a “washout.” Regardless, we'll take our evidence as it comes, and will take a more constructive investment stance if market internals improve (particularly at better valuation levels). For now, we remain defensive based on the prevailing evidence.

Notes on transportation stocks

Poor transports. In all the talk about financials, tech, consumer stocks, materials, healthcare, and industrials, the transports rarely get any attention. About the only area they get any focus at all is in Dow Theory, which focuses on the Dow Industrials and the Dow Transports, looking for joint confirmation of advances and declines in market trends. While Charles Dow strongly believed that values drive the long-term movements and returns of the markets, he also placed a good deal of attention on joint movements between the Industrials and Transports – an approach later refined by William Peter Hamilton. Though we don't use Dow Theory in our own work, the historical data suggests that it has a strong track record when it is coded into specific metrics to make it less subjective.

On that subject, Richard Russell of Dow Theory Letters notes the considerable rebound of the Dow Transportation average from its January lows, which may contain some information that the downturn in the real side of the economy (GDP, trade) may not be particularly severe (which would agree with my own expectations). I should note that Russell is in cash here, despite the strength in the Transports.

That said, I believe it would be risky to interpret the rebound in the Transports as an indication that stocks can't fall substantially further. A disproportionate share of the loss in the Dow Transports in early January was driven by two of its high-priced components, Union Pacific and Overseas Shipholding. That made the early January low more severe than it might otherwise have been, while the recovery in UNP has made the bounce stronger than it would otherwise have been as well.

The larger difficulty is that there is a long history of the Transports “whipsawing” to brief strength before plunging. The tendency for failed rallies can make it costly to place too much weight on temporary transport strength once unfavorable conditions have been defined. For example, from September 2001 to March 2002, the Dow Industrials staged a powerful bear market rally, advancing by over 25% while the Transports soared by over 40%. Yet while the Dow deteriorated toward what would eventually be new bear market lows, the Transports lagged that deterioration well into June 2002. The fact that the Transports were not breaking to new lows did nothing to prevent an ongoing bear market.

Similarly, prior to the 1987 plunge, Dow Theory gave an accurate warning, but the situation might not have appeared critical because the Transports held up well until early October. Though they did eventually capitulate to a new low on October 15, just days before the actual crash, it was a real nail-biter in hindsight. Investors ignoring the “bear market in effect” from Dow Theory, and instead counting on strength in the Transports as a positive sign, would have had very little time to respond. The following chart is from 1987 – the red line is the Transportation average.

My own impression is that relative strength in the Transports may become important if the DJIA breaks to new lows without a confirming break from the DJTA, but that aside from that consideration, the prevailing Dow Theory signal (bearish) should hold sway. Specifically, the recent strength in the Transports shouldn't encourage the pre-emptive hope of bottom picking.

Again, I should emphasize that we don't use Dow Theory in our own work, but it does have a respectable record when it is coded into objective criteria (e.g. Brown, Goetzmann and Kumar, Journal of Finance, 1988) and is well worth monitoring both to confirm and question the conclusions derived from other analysis of market action. Besides, with the mountains of coverage given to other sectors, it seemed that the recent behavior of the Transports was interesting enough to deserve a few words.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. In bonds, the Market Climate remained characterized by unfavorable yield levels and moderately favorable yield trends. The Strategic Total Return Fund is particularly defensive here, with a duration of only about 1 year, and about 20% of assets in precious metals shares.

The S&P 500 is now behind Treasury bills for the period since November 2005, which underscores the difficulty in retaining market returns that are achieved in periods of rich valuation. It's certainly possible that we will recruit enough improvement in market internals to infer that investors are once again willing to load up on market risk, but at present, we don't have that evidence.

Again, my guess, and it's just a guess, is that a sustained rally – if only a sustained bear market rally – will be more likely a) at the point that investors fully accept recession as common knowledge, so they can start putting “recession” behind them without fear that it's still ahead, or b) at the point the S&P 500 declines a full 20% from its high (anywhere below 1250) – again, so they can start putting “bear market” behind them without fear that it's still ahead. Strangely, the market often responds well when investors recognize that their fears have become reality, because at that point investors can at least begin to believe that the worst is behind them.

That doesn't mean that things won't, in fact, deteriorate beyond a 20% market decline or a shallow and well-recognized recession. But as I've frequently noted, most bear markets are not simply one-way movements. Bear markets typically comprise two, three or more separate 10-20% declines, punctuated by fast, furious rallies. It's easy to forget that the 2000-2002 bear included three bear market advances of 20% from intra-day low to intra-day high, as well as numerous smaller advances, all of which were surrendered in subsequent plunges to new lows.

This is a good time to review what bear markets look like, because even though our own focus is always on the prevailing Market Climate, an understanding of how such market periods evolve can be helpful in riding one out. As I wrote in April 2000, bear market psychology typically evolves something like this:

"This is my retirement money. I can't afford to be out of the market anymore!"

"I don't care about the price, just get me in!!"

"It's a healthy correction"

"See, it's already coming back, better buy more before the new highs"

"Alright, a retest. Add to the position - buy the dip"

"What a great move! Am I a genius or what?"

"Uh oh, another selloff. Well, we're probably close to a bottom"

"New low? What's going on?!!"

"Alright, it's too late to sell here, I'll get out on the next rally"

"Hey!! It's coming back. Glad that's over!"

"Another new low. But how much lower can it go?"

"No, really, how much lower can it go?"

"Good Grief! How much lower can it go?!?"

"There's no way I'll ever make this back!"

"This is my retirement money. I can't afford to be in the market anymore!"

"I don't care about the price, just get me out!!"

The following are actual figures and headlines from the 1973-74 bear market. At the January 1973 market peak, earnings had hit a new high, and stock prices were selling at a P/E multiple of 20, which is extreme on the basis of record earnings. Over the next 2 years, corporate earnings grew by 56%, yet the market fell by half. The 73-74 bear market teaches that stock prices can decline from rich valuations even if earnings grow dramatically:

Suppose you own stock. You have decided to be a "long term investor." Stock prices rise to a new all-time high. You feel vindicated. The economy looks great. Although market breadth has deteriorated, your commitment is firm. "I can't afford to keep my life savings out of the stock market." “Buy-and-hold” is your motto.

Then, after a modest rise in interest rates, the market sells off -12.3% in just over 2 months time. Ouch. A correction. Buy on the dip. These things happen from time to time. You're a long term investor. Buy-and-hold is your motto.

Sure enough, prices recover. Somewhat. A 4.8% advance, but already, you think, you're on your way to new highs again. Then, you lose it all in a -10.2% decline. Two months later, you've given back your advance, and you're at a lower low. Alright, another correction. Maybe you buy on the dip. Bargain prices. Buy-and-hold is your motto.

And it's already paying off. A month later, you're up 7.8% from the low. But then a -9.1% selloff takes your portfolio even lower than the first two drops. The market is down -19% overall. You start to question the amount of risk you're taking, but how much lower can it go?

Thank goodness. 15.8% advance over the next few months! Should have bought more on the last decline. Earnings are still growing strongly. You decide not to wait. You buy more on the advance, confident that you'll be rewarded by new highs. Then the market plunges -20% over the following 4 weeks. You stare at your statement and feel sick. You've held on for a year and your reward is a new low in your portfolio. This really is a bear market.

Now some volatility. Up 12% over a few months. Then you lose it all a few months later in another decline. Then another 11% advance, followed by a -12% plunge to a new low. Seven times now, you've seen your portfolio collapse by more than -10%. With every recovery, a fresh disappointment. And the months march on. It's a year and a half since the peak. You've lost nearly 30% of your wealth. Price/earnings ratios look low, but they looked low before the last decline, too. But maybe it's the bottom. After all, the average bear market takes stocks down about 30%. Holding your calculator, you realize how that works. A -30% decline wipes out a 43% gain. Didn't really consider that at the top.

Stocks rebound a little over the next month. Just 6%. You're still clinging to the bottom. Then, the bottom drops out. Not just 10%, or 15%, but a real free-fall. Over the next 6 weeks your portfolio plunges by -27%. You're another -23% down from the previous low! Almost 2 years of nothing but losses! Major ones. You've lost almost half your retirement, now. Half your life savings! And the economy has turned bad. Everybody knows that stocks were overpriced at the top! It was so obvious! Greed. Valuations were so high. Everyone was so optimistic. Why didn't you see it at the time? You decide you can't afford the risk. Sell half. See if things recover, then get back in.

Well, prices do recover. More than 15%. But then you lose it all in another selloff! Another new low! The market has lost half its value! Nine major plunges. Nearly every one to a lower low, and getting worse. This market has no support. Where are the buyers going to come from in an economy like this? People are unemployed. They don't have the income to invest! And certainly not in the stock market. The financial headlines trumpet "The Real Recession is Yet to Come", and "The Coming Dividend Crisis." Some of the less diversified mutual funds are down as much as -80% from their highs! 80%! Every $100 has collapsed to $20. If it could happen to them, it could still happen to you. This is too risky. After all, you think, "I can't afford to keep my life savings in the stock market."

"Better safe than sorry" is your motto.

That's what a bear market feels like, but we all have a tendency to forget. Though my impression is that the market is at less risk here than it was before the 1972-74 or 2000-2002 declines, it's glib to believe that rich valuations on record profit margins can be fully corrected by a 15% market decline, after which stocks will again be off to the races. As always, we'll take our evidence as it arrives. For now, we remain fully hedged.

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